One of the most important aspects of investing is knowing how to manage risk. This is where hedging comes into play. A hedge can be a particular investment or investment strategy that’s designed to insulate your portfolio against risk. Hedging may not eliminate risk entirely but it could help to minimize losses if market volatility increases or rising inflation threatens to diminish your purchasing power. There are different strategies investors can use to hedge, depending on how they’ve invested. Consider working with a financial advisor on when and how hedging makes sense for your investment strategy.
What Is Hedging?
In simple terms, hedging is a risk management strategy in which the goal is to minimize the potential for a loss. For example, if you own a home you might hedge against the risk of losses by purchasing homeowner’s insurance. Or a business owner may purchase a surplus of inventory to hedge against the risk of supply chain disruptions in the future.
Hedging is often considered to be an advanced investment strategy but at its core, it’s a straightforward concept. Typically, the main reason for using a hedging approach is to prevent investment losses as much as possible.
For example, you might review your portfolio and find that you’re holding more of a particular asset class or stock than suits your risk tolerance. You could sell off some of those investments but that could mean triggering capital gains if you realize a profit. So rather than selling, you may employ one or more hedging strategies to try and dial down some of the risk.
Why Hedging Matters
Unless you’re concentrating most of your assets in safe investments like money market accounts or bonds, risk is an unavoidable part of investing. Hedging offers a way to make that risk more manageable so that you can protect your investments against losses as much as possible. It can also help to minimize the effects of inflation on wealth.
The more hedging strategies you employ, the more you may be able to curb risk without mitigating your reward potential. So while you’re more insulated against risk your portfolio still has room to grow. The goal is to find the right balance between risk and reward so that you’re not shortchanging your investment goals.
There are different ways to approach hedging. One of the simplest is creating a diversified portfolio. For example, you may build a portfolio that includes stocks representing different market sectors, real estate investments and bonds or other fixed-income securities. Since the risk profile for each investment is different, diversifying this way can create a simple hedge against market volatility. There are, however, some more advanced hedging strategies that can be useful for managing risk.
For example, you may consider options trading. An option represents the right to buy or sell an underlying investment at a particular price point. Investors can use options to hedge against the risk of price fluctuations.
A call option allows an investor the right to buy an underlying security at the strike price. With put options, you have the right to sell the underlying security. One example of a hedging strategy using options is the long-put. With this position, you’re buying a put option on the assumption that the underlying asset’s price will decline. You can use long-puts as a hedge against a long position in the asset itself. If the asset declines in price, the long-put option can help to offset losses.
Another options hedging strategy involves the use of index options. Index options, similar to index funds, track the movements of a market index such as the Nasdaq or S&P 500. Put option strategies can also be used with index options to minimize risk as the market moves through different cycles.
Investors may also consider selling futures contracts to hedge against risk. A futures contract is an agreement to buy or sell a specific security at a predetermined price on a future date. Selling futures contracts can help to offset the risk that the asset will decline in price.
Inverse ETFs approach hedging differently. This type of exchange-traded fund uses derivatives, such as futures contracts, to place hedged bets on which way the market will go. For example, if the market declines and stock prices fall, an inverse ETF rises proportionately. You continue making money on your investments, even when the market is down.
Investing in inverse ETFs can be risky in itself, however, if you end up being wrong about which the market will move. For that reason, you’re better off using them in the near term rather than as long-term investment vehicles. It’s also important to consider that inverse ETFs may carry much higher expense ratios than standard ETFs.
Precious metals and cash
Other ways to hedge include investing in gold or precious metals or shifting some of your assets to cash. Gold prices typically increase when interest rates are falling because of an economic slowdown. Another advantage of gold is that it lacks credit or default risks. If you believe the economy is headed for a downturn or recession, gold could act as a hedge against the risk of falling stock prices.
Finally, you could hedge with cash investments. Taking money out of stocks and putting it into cash can substantially reduce risk, which is a plus when the market is volatile. The trade-off, of course, is that cash investments have less potential for growth and rising inflation can reduce your purchasing power.
Should You Hedge Investments?
Hedging can help to protect your portfolio against risk but there are some potential downsides to consider. First, many hedging strategies require some advanced investing knowledge. For example, if you plan to use options to hedge then you need to know how options work at a minimum to understand before you can dive into some of the more complex trading approaches. The same is true for futures or inverse ETFs. Otherwise, you could end up creating more risk for yourself unintentionally.
Next, it’s important to consider the costs involved. Trading options or futures may entail additional costs that you might not pay if you’re used to trading stocks or ETFs through an online brokerage that charges zero commission fees. While hedging may yield potentially higher returns those may be offset by higher fees so you have to consider whether that’s worth it.
Finally, think about your overall approach to investing. For instance, are you more of a buy-and-hold investor or do you prefer active trading? If you’re investing for the long-term, then some hedging strategies may not be as effective since you’re planning to ride out market highs and lows. Talking to your financial advisor can help you evaluate your investment approach and whether hedging makes sense.
The Bottom Line
Hedging can serve an important purpose in a portfolio for investors who are concerned about mitigating risk. Keep in mind, however, that whether it’s the right approach for you can depend on your time horizon for investing, risk tolerance and overall objectives.
Tips for Investing
- A financial advisor can point out the best ways to manage investment risk when investing for the short- or long term. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors in your local area. It takes just a few minutes to get your personalized advisor recommendations online. If you’re ready, get started now.
- One of the most important ways to ensure that you don’t take on an excessive amount of overly volatile or highly risky investments is with a proper asset allocation. A free easy-to-use asset allocation calculator can help you keep your portfolio properly balanced.
Photo credit: ©iStock.com/CIFTCI, ©iStock.com/cjp, ©iStock.com/mikolajn